Markets in panic ahead of key Fed decision 💥

Gold is back above $2,000 and WTI oil drops more than 4% ahead of a key FOMC decision❗

• Market almost fully prices-in a 25 basis point rate hike and a pause afterwards
• Swaps assume up to 2-4 rate cuts by the end of this year
• Fed should remain watchful of inflation, but also highlight recession risks and issues in the banking sector

A 25 basis point rate hike at the FOMC meeting on Wednesday, 7:00 pm BST looks like a done deal. A 50 bps rate hike looks unlikely as inflation has decelerated recently. However, there are some signs suggesting that inflationary pressures may re-emerge towards year's end. Should those signs continue to mount, Fed may stress that rate cuts this year look unlikely.

Will it be the final rate hike of a cycle?

This is the most likely scenario - Fed delivering the final 25 bps rate hike in the current cycle and warning about issues in the banking sector, which further tighten credit conditions in the United States. Also, the US central bank may stress that the labor market has cooled slightly while economic activity deteriorates. Simultaneously, Fed would likely highlight that inflation remains too high and bringing it down will require a longer period of high interest rates. Such comments may see market odds for rate cuts later this year drop.

The market expects a 25 basis point rate hike from the Fed in May, followed by 50-100 basis points of rate cuts towards the end of the year. Source: Bloomberg

Back in 2006, when the Fed delivered the final rate hike in that cycle, statement wording shifted from "need for further tightening" to "scope and timing of policy tightening will depend on economic outlook and incoming data". Such change is what we should expect from the Fed statement this week, with Fed Chair Powell reinforcing this message further during the post-meeting press conference. Such a change in Fed's narrative would likely weaken the US dollar, but its impact on Wall Street may be mixed and will depend on Fed's views on the economy. Should Fed stress that recession risk remains real, further gains on the Wall Street may be put under question.

A number of factors suggest that a US recession is looming. It should be noted that flattening of the 2y10y yield curve in previous situations hinted that recession is about to begin in 12-24 months. Source: Bloomberg

Is there a risk of inflation re-accelerating?

The latest PCE inflation data showed that price pressures are at an all-time high. Core PCE inflation is falling slightly slower than the analytical consensus expected. The overall trend against the CPI readings is downwards, but nevertheless the rate of decline in inflation is still uncertain. Yesterday's publication of the ISM index for the manufacturing sector made little difference to the market. The index rose from 46.3 to 47.1 as a result of slightly stronger orders, production and employment. At the same time, the price index also rose and returned above the 50-point threshold. This is another reminder that disinflation may seem easy now, thanks to huge base effects, but could be more difficult in the future and force the Fed to keep interest rates high for longer.

The Fed's preferred measure of inflation, PCE inflation, shows that inflationary pressures, despite the downward trend, remain strong all the time. It is worth noting that fuel prices have risen significantly in recent months, which could carry over into the overall price increase at the end of the year and provide a basis for keeping interest rates ahead of the Fed and, in an extreme situation, lead to a return to hikes. Source: Macrobond, XTB

How will USD react?

USD has been pulling back since September 2022. While the beginning of 2023 has been hectic and gave reasons to hope for larger rate hikes, turmoil in the US banking sector caused expectations for a quick end to the rate hike cycle to mount. Pullback on the USD market resumed in March. While we cannot rule out USD bulls attempting to push greenback high in the run-up to Fed's meeting this week, a pause in rate hike cycle combined with warning about rising recession risks may see USD sell-off continue. In such a situation, the first level to watch on EURUSD following Fed decision would be 1.1115 area. On the other hand, should Fed surprise with a hawkish move, a pullback towards 1.08 area cannot be ruled out.

 Source: xStation5

Market sentiment during today's session is clearly recessionary. In addition to declines in the stock market, we are seeing huge declines in the price of WTI, which is currently trading 4% below the dash. Gold, on the other hand, is gaining on the wave of economic uncertainty, climbing above the $2,000 area. Source: xStation 5